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Economics of the Minimum Wage

Minimum wage debates tend to overstate the estimated and real effects of any changes to the minimum wage in the Unites States. Most studies show a minor increase in a place with wages already rising has no significant effect on employment. But, there is a cost when wages rise quickly and there is an effect when wages fail to keep pace with the cost of living. The problem is that the minimum wage is not, contrary to any mythologies, the income of most adults with full-time work.

As the debates below suggest, there is a limit to what a local economy can bear in terms of wage growth. At the same time, we know that low wages also reflect jobs that can be or will be automated away in many instances. We are in a new era of creative destruction, with no real plan for the displaced workers without skills.

Allow me to provide an example of how silly on all sides the debate on wages is. Mark Perry gets the facts right in his piece on the AEI website, but his tone is destructive to the argument.

Writing in The Atlantic, law professor James Kwak makes a very ill-advised case for ignoring economic theory, logic, laws and reasoning and supporting higher government-mandated minimum wages for unskilled workers in an essay ("The Curse of Econ 101") that I would characterize as a 3,000-word logorrheic bouillabaisse of misunderstandings, non sequiturs, half-truths, and false presumptions (to channel Don Boudreaux). It ranks right up there along with articles by John Komlos ("Why a $15 minimum wage shouldn't scare us") and "America's Worst Minimum Wage Pundit" Nick Hanauer ("The claim that if wages go up, jobs will go down is not a theory — it's a scam") as one of the most misinformed, flawed and misguided articles ever written about the minimum wage.

With a tone like that, even the best argument isn't going to persuade someone adhering to the dream of a higher minimum wage somehow transforming America. If anything, the tone turns people away from the statistical evidence.

And the evidence is stronger than politicians and activists want to consider.

The law professor, James Kwak, has treated us to his thoughts on the minimum wage. The essence of which is that there's just too much economics 101 going on here, people just aren't grasping the complexity of the subject. There being a couple of problems with this assertion. The first is that Kwak has missed that all economists, without fail, agree that the economics 101 explanation is true at some level of a minimum wage. Make a minimum wage "too high" and it will produce significant unemployment effects. The only debate actually happening within economics is what is that definition of too high? The second is that Kwak doesn't actually understand that what he thinks he knows about it is not what is actually known about it.

Kwak: …a higher minimum wage will raise labor costs. But many companies can recoup cost increases in the form of higher prices; because most of their customers are not poor, the net effect is to transfer money from higher-income to lower-income families.

No, this has been studied. The majority of people earning minimum wage are not in poor households. But the majority of people consuming the products of minimum wage labour are themselves in the lower reaches of the income distribution. After all, we're not going around saying that Walmart's target market is the upper middle classes, are we? Changes in wages there, changes in prices there, are going to affect the lower ends of the income distribution therefore. And when we do more detailed empirical studies we find that the majority of a minimum wage rise would not go to the poor but the majority of the costs of higher prices would. The actual effect is the opposite of that assumed by Kwak.

Worstall mentions that the majority of minimum wage earners are not from poor households. How can this be? Curiously, the majority of minimum wage earners are the at-home children of middle-class parents and college students working while in school. The majority are not heads of households or independent adults. That's important because increases in wages do result in slower hiring… but that slower and more selective hiring appears to favor the middle- and upper-class families.

This is not to say some adults are not stuck in minimum wage jobs. From the BLS data:

Although workers under age 25 represented only about one-fifth of hourly paid workers, they made up about half of those paid the federal minimum wage or less. Among employed teenagers (ages 16 to 19) paid by the hour, about 11 percent earned the minimum wage or less, compared with about 2 percent of workers age 25 and older.

Among those paid by the hour, 870,000 workers earned exactly the prevailing federal minimum wage of $7.25 per hour. About 1.7 million had wages below the federal minimum (this includes a variety of workers exempt from minimum wage: in-prison workers, children working for family, some special work-study program, and tipped workers).

The percentage of hourly paid workers earning the prevailing federal minimum wage or less declined from 3.9 percent in 2014 to 3.3 percent in 2015. This remains well below the percentage of 13.4 recorded in 1979, when data for hourly-paid were first collected on a regular basis.

Yes, two percent of workers 25 and older earn the minimum wage or less. That's a bit under a million people in that age group. (Remember, of the 2.1 million total earning minimum or less, half are 16 to 25.)

How do you help the working-age adults over 25 earning a paltry salary? Skills and education are the only real answer. Plus, we do have to consider solutions such as a minimum basic income based on regional costs of living. But, this is not as many people as some imagine.

Then, we have the argument that raising wages results in better employees. That's only true if the wagers are higher compared to other potential wages in other jobs. We compare ourselves and our economic situations to other people. If you are "relatively" poor or "relatively" behind other people, you feel worse about the economy — even as you have a much higher standard of living than anyone from 50 years ago.

Raising someone's wage only makes that person feel better if they believe their lifestyle is improving compared to the situations around them. But, Kwak makes an erroneous argument, ignoring this relative nature of economic security.

Kwak: In addition, companies that pay more often benefit from higher employee productivity, offsetting the growth in labor costs.

Even Paul Krugman has pointed out the error with this one. You only get that higher productivity by paying more than other employers. A general rise in the wage rate doesn't produce that higher productivity.

Justin Wolfers and Jan Zilinsky identified several reasons why higher wages boost productivity: They motivate people to work harder, they attract higher-skilled workers, and they reduce employee turnover, lowering hiring and training costs, among other things.

All true but it's from higher than other [people's] wages.

Simply: If I'm still not catching up to other people, or passing them by economically, I don't feel like my pay increased.

Now, if I change jobs and my former coworkers stay behind while I earned a raise by making this choice, then I feel much better. We feel better when we do better than others. Maybe it is envy. Maybe it is selfishness. But, that's what economists an psychologists have learned. If everyone receives a pay increase, nobody feels better once the immediate euphoria vanishes. We look around and realize, "Wait a minute! We're still equals!"

The reason someone at Acme Widget feels better than someone at Pinnacle Widget is because the Acme Widget employees sense they are better paid than their colleagues. They sense that Acme values them more than Pinnacle. But, if both companies give the same raise and set the same base pay… nobody feels better.

Krugman: They also argue that because there are cases in which companies paying above-market wages reap offsetting gains in the form of lower turnover and greater worker loyalty, raising minimum wages will lead to similar gains. The obvious economist's reply is, if paying higher wages is such a good idea, why aren't companies doing it voluntarily? But in any case there is a fundamental flaw in the argument: Surely the benefits of low turnover and high morale in your work force come not from paying a high wage, but from paying a high wage "compared with other companies" — and that is precisely what mandating an increase in the minimum wage for all companies cannot accomplish.

Psychologists and behavioral economists have found, repeatedly, that Kwak's claim that higher wages also attract people back into the workforce is right only if the benefits of work significantly (by nearly 150%) outweigh not working. In other words, if I receive $10 an hour for not working, it might take $15 an hour for me to work. (Some economists have pointed out that the "take home" pay for $15 is about $10, which might explain this problem.) This also explains why cutting unemployment benefits is as effective at returning people to work as raising wages. This happened with welfare reform during the Clinton administration. People do a cost-benefit analysis, even if they don't realize they are doing so.

Kwak again: A higher minimum wage motivates more people to enter the labor force, raising both employment and output.

That raises unemployment. Sheesh. So, more of those 96 million not currently working think that wages are now high enough to tempt them to go look for work. That means they've gone from being happily economically inactive to being, presumably, unhappily searching for work. Or, as we use the word, unemployed.

Worstall correctly points to something else discovered during the welfare reform of the late 1990s: people looking for work feel worse than people on federal aid. I find this hard to believe, on the face of it, but data are there to suggest looking for work causes more stress and anxiety. Job hunting for more than six months corresponds to depression.

If a minimum wage increase encourages people to look for work, we need to help those people find jobs quickly and jobs that are matched to their abilities.

The final argument from Kwak addressed by Worstall is also a common misconception based on historical data: increases in the minimum wage don't increase buying power. However sad that is, the increases tend to remain flat, in terms of actual buying power. This is the "meal deal" problem: increase the minimum wage, increase the price of the meal at a fast food restaurant. We can argue about why the poor eat more fast food and why they should buy fresh groceries, but studies find that increases in the minimum wage lead to increased prices for the goods and services at the low-end of the economy.

This effect does indeed exist. But it's also not very large. It's the marginal propensity to spend, or the inverse to save, here. And it will be in the 10 – 15% range of the change in wages, not the total amount of wages itself. And we do also need to note that the economy does not live by consumer demand alone. Investment, financed from savings, also matters. And the very contention is that we're moving stuff from savings by richer people into consumer demand by poorer people. Thus even though the increase in consumer demand is definitely there it's not entirely obvious that the fall in savings and investment on the other side does not cancel out the effect.

Walmart and McDonald's pay at the low-end of the wage scale. They also serve people at the bottom of the economic ladder. These businesses are the most price sensitive.

The Los Angeles Times reported that "highly rated" restaurants were not hurt by higher wages. Okay, but think about their customer base. Low-rated, chain and fast-food restaurants are hurt. Where are those located? To whom do they serve? So, yes, a $50 per diner establishment adjusts. A $4.99 per burger place does not.

It's not so simple, unless you happen to eat at $50/person restaurants and your teenage child works part-time at a local retail store. Then, increases in the minimum wage make perfect sense.

It is like arguments about sin taxes. The rich are least likely to smoke or drink heavily. The sin taxes hurt the poor most. We can argue that the taxes exist to stop the behavior, but if that's the case, then why fund any essential or good programs with that same tax money — clearly if people stopped smoking, there'd be less tax revenue.

From a distance, higher minimum wages and higher sin taxes both make sense. In a struggling neighborhood with fast food and over-priced (limited) grocery options, things are less clear.

The minimum wage will likely be increased in many more states. If the increases simply reflect already existing wage pressures and inflation, the new wages will have few negative consequences. It's all a matter of how jarring an increase might be.

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